Capital quandary

Only a fraction of the world’s SMEs are funded by public equity. ACCA considers whether the world’s capital markets can do more for small issuers.

Xavier Rolet, CEO of the London Stock Exchange Group, has been making the rounds recently, drumming up support for Europe’s SMEs as the most reliable job creators in the region. He’s right, of course, in identifying the sector as a powerful engine of employment, but can the capital markets supply SMEs’ funding needs?

The dotcom boom of the late 1990s ended badly – or so I was taught in university. But more than a decade later it seems to me that it was a fantastically benign episode compared to the credit bubble that followed it. Though it had to end some time, it was the dotcom era that made today’s digital economy possible, bequeathing a digital and social infrastructure that we couldn’t live without today.

But perhaps the period’s most lasting legacy may be the stereotype of the twentysomething internet billionaire: starting a game-changing business in his or her basement, then taking it public a few years later, still in jeans, as the prospectus presented to the world. It’s a great story, but also a desperately rare one.

To this day, only a very small percentage of the world’s SMEs are funded by public equity. The figure varies by country but is typically in the low single digits. Because the total population of SMEs is so massive, this relatively small share still means that micro-caps and small caps (with a market capitalisation of less than $65m and $200m respectively) made up 64% of the world’s listed companies in 2011. But they accounted for only 14% of individual stock market trades and 4% of share trading volume, according to figures from the World Federation of Exchanges.

Illiquidity is a market-killer. It scares away investors looking for reliable exit opportunities as much as it does entrepreneurs looking for fair valuation. It also endangers the social mission of markets. Stock exchanges serve society by channelling funds to productive investment through price discover; this however means that liquidity is most crucial in those segments of the market in which issuers most critical future finance needs are still ahead of them.

Appropriately a recent report by UK think tank Centre Forum singled out stamp duty on sales of shares for criticism as an effective tax on liquidity. In the era of high frequency trading, some policymakers may even welcome this outcome. But even if there is such a thing as excess liquidity in capital markets – which is subject to fierce debate – when it comes to small listings, there is no liquidity to waste, no froth to skim.

Governments have used other tax incentives extensively to promote equity finance; after all the interest on debt is tax-deductible, which creates an uneven playing field. Emerging markets, from Jamaica and Trinidad and Tobago, to frontiers such as Cambodia, offer substantial tax breaks to listed firms, subject to clawbacks, as long as they remain listed for some years. Many governments also extend these breaks to investors. In the UK, for example, investments in the AIM exchange are now eligible for inclusion in stocks and shares ISAs.

While tax relief may encourage investors to hold onto more of their gains, the ears of tax and wealth advisers everywhere also prick up at the mere mention of a tax incentive. Tax relief may increase returns, but it is only one side of the equation. Small issuers are seen as riskier – and not without cause. Students of accounting are routinely taught from seminal studies that use business size is a proxy for risk. The lack of analyst following compounds this problem: analysts’ incentives are to generate recommendations for the sell-side and micro-caps simply cannot generate enough sales to justify their time. It is not impossible to develop alternatives, but they won’t come for free either.

Back in the UK, Centre Forum correctly identified the need for a new listing culture in which all stakeholders collaborate to encourage the financing of SMEs through public equity. Ironically, this is precisely the reality in less developed markets – where government, business associations, exchanges and the accountancy profession work hand in hand to groom prospective issuers.

Why not take a leaf out of their book? After all, secondary boards aimed at SMEs, however established the main exchange boards they are allied to, are perpetually in frontier market territory.

Meanwhile, the tiny but rapidly growing crowdfunding industry, which allows retail investors to put small amounts of equity towards promising start-ups, could introduce a whole new generation of potential investors to the concepts and risks of equity investment. Policymakers and exchanges have yet to see the link between crowdfunding and the capital markets, but they should.